Fixed Income Quarterly Outlook – Q2 2020

Debt: the hair of the dog that bit me

Key Points

It is possible that debt levels could rise much higher than we might think without spurring an increase in government bond yields, that is, as long as there is either a sufficient number of willing domestic investors or a willing central bank to buy the debt.

One of the most immediate concerns is the economic outlook and whether enough fiscal and monetary support is being provided to offset the impact of the social distancing measures imposed to combat the virus.

If citizens are kept home for too long and businesses remain shut, the odds rise of a much bigger increase in business failures, high levels of unemployment and the inability of governments to fully replace the lost activity. Governments cannot borrow a year’s worth of GDP.

Encouragingly, estimates for the year as a whole are less dispersed as the steep fall in the second quarter is expected to be followed by commensurately large rebounds in the third and fourth. But estimates for the full year, currently average -4.4%, are worse than the 3.9% fall in GDP during the global financial crisis.

Macroeconomic Context

One of the inevitable consequences of the global coronavirus recession looks set to be a large increase in the level of government debt. To the degree that the 2008 global financial crisis and the 2011-12 eurozone crisis were caused by excessive leverage, addressing the current crisis with more debt might not seem to be the best solution. But in much the same way as more alcohol is preferred as a solution to a hangover (“the hair of the dog that bit me”), more debt seems to be the solution to the economic collateral damage caused by necessary government measures to combat the coronavirus pandemic.